sound money An Austrian proposal for free banking, NGDP targets, and OMO reforms Anthony J. Evans The Adam Smith Institute has an open access policy. Copyright remains with the copyright holder, but users may download, save and distribute this work in any format provided: (1) that the Adam Smith Institute is cited; (2) that the web address adamsmith.org is published together with a prominent copy of this notice; (3) the text is used in full without amendment [extracts may be used for criticism or review]; (4) the work is not re–sold; (5) the link for any online use is sent to info@ adamsmith.org. The views expressed in this report are those of the author and do not necessarily reflect any views held by the publisher or copyright owner. They are published as a contribution to public debate. © Adam Smith Research Trust 2015 Published in the UK by ASI (Research) Ltd. Some rights reserved Printed in England CONTENTS Executive summary xii Foreword ix Introduction xv 1 Open Market Operations 1 1.1 The Sterling Monetary Framework 2 1.2 Merging liquidity provision and monetary policy 6 1.3 Five reforms for OMO 9 2 NGDP Targets 19 2.1 Austrian foundations 23 2.2 The pros and cons 26 2.3 Market monetarism 29 2.4 Limits of NGDP targets 32 3 Free Banking 53 3.1 What is a “free” bank? 57 3.2 Is there a limit on credit creation under free banks? 59 3.3 Are private banks prone to bank runs? 61 3.4 Are central banks necessary? 65 3.5 Are central banks the natural consequence of the market? 67 3.6 Would a Free Banking system improve macroeconomic stabilisation? 69 4 Conclusion 75 Appendix 81 References 85 Executive summary • This paper applies a free market approach to monetary theory to critically assess recent UK monetary policy. In particular, it advo- cates the following reforms: i) punitive but open access OMO, ii) a NGDP average growth target of 2%, and iii) free banking. • Although each of these steps is progressively less feasible (both politically and technically), it is argued that they are progressively more desirable. • Instead of viewing this as a trade off, the three proposals are designed to lead into each other. • Hence improvements to how QE is conducted is a stepping- stone to NGDP targeting: whilst NGDP targets are a second best improvement on the status quo, they are primarily advocated as an intermediate step towards the ultimate goal of free banking. Foreword “First, second, and third best policy prescriptions: An Austrian pro- posal for free banking, NGDP targets, and OMO reforms” makes major contributions to a profound but much misunderstood subject – the nature of our monetary order. More precisely, it addresses the role of the central bank and whether we should even have a central bank in the first place. As such, it offers a major challenge to the failed conventional wisdom that takes central banking and Keynesian eco- nomics for granted, but fails to see that these are not the solutions to our current economic malaise, but are actually its root causes. The author, Dr Anthony Evans, is ideally suited to make such a chal- lenge. Anthony is, without a doubt, one of the best of the up-and- coming generation of free market economists: a highly original and much regarded thinker with an remarkably wide range of interests including money and banking, political economy, managerial and cultural economics, and much else besides. He is a faculty member of the ESCP Europe Business School and a member of the Shadow Monetary Policy Committee run by the Institute of Economic Affairs. Anthony’s monograph consists of three key sections and an appen- dix. These can be read as independent proposals, but are better read as components of a broader reform strategy designed to achieve a free X SOUND MONEY banking system. In this context, free banking is not charge-less per- sonal banking, as a casual web search might suggest, but something much more profound: a system of financial and monetary laissez-faire with no central bank. As Anthony points out, such a system would be much more stable than the system we have today; indeed, perhaps the strongest argument for free banking is that it would have made the Global Financial Crisis (GFC) impossible. Had we had free banking, there is no question that we would now be living in a much safer and much more prosperous world. The first section provides a critique of Quantitative Easing (QE) and offers suggestions on how to improve open market operations (OMO) – essentially proposing punitive open-access OMO. You can regard this as a third-best solution to improve the operation of monetary pol- icy – and a very welcome one it is too. The second section proposes to move to a Nominal Gross Domestic Product (NGDP) average growth target of 2% - a target that would also deliver an outcome close to price stability over the longer run, but offer some short-run countercyclical offsets – as a replacement for the current policy ‘rule’ that ostensibly aims for a 2% inflation target, but in reality merely provides a smokescreen for unbridled monetary policy discretion, i.e., no monetary policy rule at all. You can regard this proposal as a second-best solution that would produce a superior monetary policy. The third section then discusses the first-best solution, free banking, and the appendix outlines a plan to implement free banking in a real- istic time frame. Thus, each step is designed to lead to the next, i.e., Anthony offers not just another proposal for free banking but also, more helpfully, a transition strategy to get us from ‘here’ to ‘there’. SOUND MONEY XI Of course, advocates of the Keynesian central banking conventional wisdom will be quick to dismiss such radical thinking as ‘unrealistic’ and so forth: they always do. These are the same people whose quack medicine – in effect, just give the patient more stimulus, however over-stimulated the patient already is, like a doctor telling an alco- holic patient to drink a lot more. The problem is that it is exactly this thinking that got us into this mess in the first place. Well, faced with a choice between faking an alien space invasion to boost spending even more and equally silly proposals to implement negative interest rates and abolish cash, or adopting a sensible pro- posal that would make the financial system safe and rule out another GFC in the future, I think we have a no-brainer. But one thing is for sure: the conventional wisdom is well and truly discredited and any solution must be a radical one well beyond its limited mindset. I am immensely grateful to Anthony for a highly original contribution to the growing literature on free banking. I hope his work will stimu- late further work on this most important but neglected of subjects – and I look forward to much more from him in the future. I used to joke to my students that I was the only academic in the UK to advocate free banking. This was true for a painfully long time, but no longer. UK central bankers be warned: there are now two of us. Kevin Dowd Professor of Finance and Economics Durham University November 24 2015 There is no economic reason why the determination of a unit of account linked with a medium of exchange and the provi- sion of outside money cannot be left to the market. Milton Friedman and Anna Schwartz1 1 Friedman & Schwartz (1986, p.49). Introduction By the end of his career, theory and evidence (not to mention the influence of his co-author) had led Milton Friedman to give seri- ous consideration to radical monetary economics.2 Since his death in 2006 we have experienced a global financial crisis, and unprece- dented interventions from central banks. Sadly, the ideas Friedman was coming round to adopt have been far from the top table of debate. This policy paper presents three different proposals as part of a gen- eral strategy to liberalise the monetary system. In particular it will advocate reforms to open market operations (OMO); an NGDP tar- get; and outright Free Banking. Monetary policy matters because errors in either direction will lead to recessions. If monetary policy is too loose there will be an infla- tionary boom followed by a correction. If monetary policy is too tight there will be a slowdown in growth and jobs.3 To look at this in more detail consider a dynamic form of the famous equation of exchange: 2 On Anna Schwartz’s influence on Friedman see Selgin (2012d). 3 I am assuming that prices are not perfectly flexible. The former situation is the standard Austrian theory of the trade cycle, whilst the latter holds for Keynesian and Monetarists as well. XVI SOUND MONEY Here, the variables are growth rates and this is why we use their sum, as opposed to the more traditional version of the equation in which we use the product.4 Y is the growth rate of output. Over time it will reflect the poten- tial growth rate of the economy, which is determined by real factors (i.e. by anything that affects the productivity of labour or capital). Therefore a positive real shock will cause Y to increase, and a neg- ative real shock will cause Y to fall. Y is typically measured by real GDP.5 P is inflation, and whilst we’re employing aggregate variables it’s important (as we shall see) to still pay attention to changes in relative prices.